In the late 1990s, the IRS and Treasury published entity
classification regulations under Sec. 7701 (check-the-box regulations)
that were designed to simplify the lives of both taxpayers and the
government. The purported simplicity of those regulations, however, may
give rise to traps for the unwary in certain

situations. This item describes one such potential trap, involving
the effective date of an election, and discusses how to address it.

To appreciate the issue fully, some background information is
necessary. Specifically, one must have some knowledge of the
check-the-box regulations, the liquidation-reincorporation doctrine and
exceptions to its application, and the consequences of the regulatory repeal of the Bausch & Lomb doctrine.

Overview of the Check-the-Box Regulations

The check-the-box regulations set forth rules for classifying
business entities for federal tax purposes. Under those rules, an
eligible entity with just one owner may elect to be classified as a
corporation or as an entity disregarded as separate from its owner
(disregarded entity). Under Regs. Sec. 301.7701-3(g), if an eligible
entity classified as a corporation elects to change its classification
to be treated as a disregarded entity (disregarded entity election), the
corporation is deemed to liquidate by distributing all of its assets and
liabilities to its single owner (the deemed liquidation). The tax
treatment of the deemed liquidation is determined under all relevant
provisions of the Code and general principles of tax law, including the
step-transaction doctrine.

Regs. Sec. 301.7701-3(g)(3) (the effective date provision) provides
that the deemed liquidation occurs immediately before the close of the
day before the effective date of the disregarded entity election. Thus,
if an entity classified as a corporation files a disregarded entity
election effective on January 1, the deemed liquidation is treated as
occurring immediately before the close of December 31.

It is the effective date provision that raises the potential issue
discussed in this item. To illustrate, consider the following examples.

Example 1: X, an entity classified as a corporation, owns all the
stock of both Y and Z, each of which is also classified as a corporation
for federal tax purposes. On January 1, 2008, x contributes all Y's
stock to Z (the stock contribution). Immediately thereafter and pursuant
to the same plan, Y files a disregarded entity election (Y's
election) effective on January 2, 2008. Under the effective date
provision, the deemed liquidation of Y occurs at the end of January 1,
2008 (and thus at a time when Y is owned by Z). Thus, for federal tax
purposes, the transactions to be examined (and potentially recast) are
X's contribution of all Y's stock to Z, followed by a
liquidation of Y in which Y distributes all its assets (subject to its
liabilities) to Z.

Example 2: Assume the same facts as in Example 1, except that
Y's election is effective on January 1, 2008--the date of the stock
contribution. Now, under the effective date provision, the deemed
liquidation of Y occurs at the end of December 31, 2007--a time when Y
is owned by X. Thus, for federal tax purposes, the transactions to be
examined (and potentially recast) are a liquidation of Y into X,
followed by X's contribution of the former Y assets (subject to the
former Y liabilities) to Z.

The Liquidation-Reincorporation Doctrine

It has long been the IRS's position that a corporation's
purported liquidation that is preceded or followed by a transfer to
another corporation of all or part of the liquidating corporation's
assets may be recharacterized in accordance with its substance (see,
e.g., Regs. Sec. 1.331-1 (c)). This position, commonly referred to as
the liquidation-reincorporation doctrine, generally results in the
treatment of a liquidation of a wholly owned subsidiary followed by the
parent's reincorporation of all or substantial part of the assets
received in the liquidation in another, existing wholly owned subsidiary
as a reorganization under Sec. 368(a)(1)(D) (a D reorganization) for
federal tax purposes.

Historically, that treatment would prevail regardless of whether
(1) the parent contributed the target corporation's stock to
another subsidiary and the target liquidated (as in Example 1) or (2)
the target corporation liquidated into the parent and then the parent
contributed the target's assets to the other subsidiary (as in
Example 2). Thus, given that the stock contribution and Y's
election in both examples occur as part of the same plan, a
knowledgeable federal tax practitioner might assume that the federal tax
treatment of the transactions in Examples 1 and 2 should be the same. As
discussed below, however, that may not necessarily be the case.

Exceptions: The IRS may assert that the liquidation-reincorporation
doctrine does not apply to situations in which the liquidation occurs in
a transaction that also qualifies as a reorganization under Sec.
368(a)(1). For example, in Rev. Rul. 69-617, the IRS examined the
federal tax treatment of an acquisition by a parent corporation (P) of
all the assets of its partially owned subsidiary (S1) in a statutory
merger, followed by P's immediate transfer of all the assets
received in the liquidation to a newly formed corporate subsidiary (S2)
of P. Clearly, under the liquidation-reincorporation doctrine, the
acquisition by P and subsequent transfer of S1's assets to $2 could
have qualified as a reorganization in which S2 directly acquired all
S1's assets. In the ruling, however, the IRS concludes that the
merger of S1 into P qualifies as a reorganization under Sec.
368(a)(1)(A) (an A reorganization). The subsequent transfer of S1's
assets to S2 was a transfer of assets acquired in the reorganization to
a subsidiary controlled by P, as permitted under Sec. 368(a)(2)(C).

By way of background, Sec. 368 (a)(2)(C) provides that a
transaction qualifying as a reorganization will not be disqualified solely because some or all of the assets acquired in the reorganization
are transferred to a corporation that the acquiring company controls.
One rationale for the IRS's position in Rev. Rul. 69-617 may be
that the mere existence of Sec. 368 (a) (2) (C) "stops" the
step-transaction doctrine from recharacterizing an upstream transaction
that qualifies as a reorganization followed by a contribution of all the
acquired assets in a Sec. 368(a)(2)(C) contribution.

Another possible rationale may be that the facts of this ruling
state that the minority shareholders of S1 received P stock in the
merger. Note that if the transaction is treated as an A reorganization,
the receipt of the P stock is tax free to that minority. If, however,
the overall transaction were tested as a D reorganization, the minority
shareholders would have been taxed on the receipt of the P stock became
P stock is not qualifying consideration in a D reorganization in which
S2 acquires S1's assets. Perhaps the potential whipsaw effect
illustrated by the IRS's loss in King Enterprises, 418 F2d 511
(1969), earlier that same year influenced the ruling's outcome.

Repeal of the Bausch & Lomb Doctrine

The upstream transaction described in Rev. Rul. 69-617 qualified as
a reorganization under Sec. 368(a)(1)(A) (an A reorganization) because
it occurred under a state merger statute. In contrast, the deemed
liquidation in Example 2, above, occurred as a result of a disregarded
entity election and does not qualify as an A reorganization. But could
it qualify as some other type of reorganization? The most likely
candidate would be a Sec. 368(a)(1)(C) reorganization (a C
reorganization), but historically that treatment would have been
prevented by the Bausch & Lomb doctrine (see Bausch & Lomb
Optical Co., 267 F2d 75 (2d Cir. 1959)).

For transactions occurring after December 31, 1999, however, Regs.
Sec. 1.368-2(d)(4) repeals the Bausch & Lomb doctrine. Thus, an
upstream liquidation of a wholly owned subsidiary into its parent (or
deemed liquidation of a subsidiary as a result of a disregarded entity
election) occurring after December 31, 1999, may qualify as a C
reorganization. As discussed further below, if the deemed liquidation of
Y into X in Example 2 qualifies as a C reorganization, the IRS may
attempt to turn off the application of the liquidation-reincorporation
doctrine and thus set up a potential disparity in the federal tax
treatment of Examples 1 and 2.

Possible Federal Tax Treatment

Applying general principles of federal tax law, including the
step-transaction doctrine, to the facts in Example 1, it is relatively
clear that the integrated transaction should be treated as a D
reorganization of Y into Z (see, e.g., Rev. Rul. 67-274). One would
think that those same general principles of federal tax law should apply
to integrate the transactions in Example 2, resulting in the same
treatment as in Example 1. Nevertheless, the possibility that an
upstream liquidation might qualify as a C reorganization under current
law (if such treatment turns off the step-transaction doctrine) could
have a profound effect on the treatment of the Example 2 transactions.

At this point, the reader may wonder why the X-Y-Z group in our
examples would care whether the transactions in Example 2 are treated as
a D reorganization or a C reorganization followed by a Sec. 368(a)(2)(C)
contribution of assets. In either situation, the transactions are
seemingly tax flee to all the participants. Moreover, regardless of
which characterization applies, Z's basis in Y's assets will
equal Y's basis in those assets immediately prior to the
transactions.

There are, however, important differences in the consequences of
the transactions, depending on which characterization applies. For
example, because a Sec. 368(a)(2)(C) contribution is not a Sec. 381
transaction, the characterization of the transaction may affect the
location of Y's federal tax attributes when the transaction dust
has settled. Further, in the consolidated group context, there may be
unexpected (and likely unintended) consequences to the group if there is
a deferred gain with respect to X's stock in Y (see Regs. Sec.
1.150213(f)(5)(ii)(B)).

The differences could be even more profound in an international
context. For instance, in Example 2, assume that X is a domestic
corporation, while both Y and Z are foreign corporations. If the
transactions in Example 2 are integrated and treated as a direct
acquisition by Z of all the Yassets from Y, the transactions would be
treated as a foreign-to-foreign D reorganization of Y into Z. On the
facts described, that transaction should not give rise to income or gain
recognition for any of the parties involved (see Regs. Sec.
1.367(b)-4(b)).

In contrast, if the transactions in Example 2 are treated as an
upstream C reorganization in which X acquires all of Y's assets and
then contributes them to Z in a permissible Sec. 368(a)(2)(C)
contribution, the federal tax consequences are quite different.
Specifically, the upstream C reorganization of Y (a foreign corporation)
into X (a domestic corporation) would be a repatriation of foreign
corporate assets in a nonrecognition transaction. As a result, under
Regs. Sec. 1.367(b)-3(b)(3), X would be required to include in income as
a deemed dividend the "all earnings and profits amount" (as
defined in Pegs. Sec. 1.367(b)-2(d)) with respect to its stock in Y.
Depending on certain factors, including but not limited to the length of
X's ownership of Yand the profitability of Y during that period,
that could result in a substantial income inclusion for X, even if there
is little or no gain inherent in X's stock in Y.

In addition, the Sec. 368(a)(2)(C) contribution of Y's assets
by X (a domestic entity) to Z (a foreign corporation) would be an
outbound contribution of those assets subject to Sec. 367(a). Under that
section, such a transfer will be completely taxable to X unless and to
the extent that exceptions to the general recognition rule apply (e.g.,
the assets transferred are used in an active trade or business outside
the United States or the assets transferred are stock and securities in
a foreign corporation and a gain recognition agreement is filed).
Depending on the amount of gain inherent in Y's assets (which
amount would not be reduced by the all-earnings-and-profits inclusion
occurring as a result of the upstream C reorganization), that Sec.
367(a) "toll charge" could result in a substantial amount of
federal tax for X.

Which Treatment Should Apply?

In the author's view, the transactions in Example 2 (like
those in Example 1) are better viewed as a D reorganization of Y into Z.
First, there is no substantive difference between the two examples; it
is only the effective date of the Y election that changes (by one day).
Treating the two transactions in two different ways for federal tax
purposes would exalt form over substance, something generally frowned
upon in the federal tax world.

Second, the liquidation-reincorporation doctrine developed out of a
long line of arguments set forth by the IRS and adopted by the courts to
recharacterize liquidations followed by reincorporations as D
reorganizations--even when the transaction at issue did not satisfy the
technical requirements for such treatment (see, e.g., Davant, 366 F2d
874 (5th Cir. 1966)). The apparent trend favoring D reorganization
treatment for asset transfers between related corporations is reflected
in Sec. 368(a)(2)(A) (providing that a transaction that is both a C
reorganization and a D reorganization is treated as a D reorganization,
except for purposes of determining whether Sec. 368(a)(2)(C) applies).

Moreover, this preference for D reorganization treatment recently
culminated in the IRS's issuing temporary regulations under which
stock is deemed issued in certain transactions involving corporations
held by the same shareholders, such that those transactions may qualify
as D reorganizations even though no stock in the acquiring company is
actually issued in the transactions (see Temp. Regs. Sec. 1.368-2T).

Further, in the international context, treatment of the transaction
as an upstream C reorganization followed by a contribution appears
incorrect from a policy perspective. Although the check-the-box
regulations provide that the disregarded entity election gives rise to a
deemed liquidation for federal tax purposes, in fact, Y's assets
never leave the foreign jurisdiction. Because Y remains an actual legal
entity under foreign law, a foreign entity actually continues to own
those assets at all times. In such a situation, it would seem odd for
the IRS to argue that the better treatment of the transactions is a
deemed inbound transaction followed by a deemed outbound transaction,
when a result more reflective of the actual circumstances is available.

Finally, Sec. 368(a)(2)(C) was added to the Code to prevent the
step-transaction doctrine from applying to convert a transaction
otherwise qualifying as a reorganization into a taxable transaction solely as a result of a post-transaction shuffling of assets within a
controlled group of corporations. This was done in response to the
"remote continuity of interest" concerns presented by the
Supreme Court's decisions in Groman, 302 US 82 (1937), and
Bashford, 302 US 454 (1938). In contrast to that goal, applying Sec.
368(a)(2)(C) to prevent Example 2 from qualifying as a
foreign-to-foreign D reorganization in the international context
described above can, in certain situations, convert an otherwise
tax-flee transaction into a taxable transaction--solely as a result of a
poor or uninformed choice of an election's effective date. For
these reasons, the deemed liquidation and the stock contribution
occurring under the same plan should be treated as a D reorganization,
regardless of the effective date of the election.

The Easy Fix

Notwithstanding the arguments above, it is possible that the IRS
could assert that the transactions in Example 2 should be treated as an
upstream C reorganization of Y into X followed by a Sec. 368(a)(2)(C)
transfer by X of the former Y assets to Z. And, as discussed above, such
an assertion could have a significant tax cost. If the parties want to
avoid that characterization, however, Example 1 illustrates how that may
be accomplished. Quite simply, Y should elect to be treated as a
disregarded entity effective on the day after Z acquires all of Y's
stock. In the international context described above, this ensures that
Y's liquidation is treated as occurring when Z, a foreign
corporation, is Y's sole owner. In such a situation it is
relatively clear that the stock acquisition and the liquidation should
be treated for federal tax purposes as a foreign-to-foreign D
reorganization of Y directly into Z. Thus, the potential inbound and
outbound transactions are avoided entirely.

FROM DEANNA WALTON HARRIS, J.D., LL.M., WASHINGTON, DC

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